Variable Annuity Definition

What is a variable annuity?

A variable annuity is a type of annuity contractwhose value may vary depending on the performance of an underlying portfolio of sub-accounts. Sub-accounts and mutual funds are conceptually identical, but sub-accounts do not have stock symbols that investors can easily enter into a fund tracker for research purposes. Among annuitiesvariable annuities differ from fixed annuitieswhich offer a specific and guaranteed return.

Key points to remember

  • The value of a variable annuity is based on the performance of an underlying portfolio of sub-accounts selected by the owner of the annuity.
  • Fixed annuities, on the other hand, offer a guaranteed return.
  • Variable annuities offer the possibility of higher returns and greater income than fixed annuities, but there is also a risk that the account will lose value.

Understanding variable annuities

There are two things that contribute to the value of a variable annuity: the capital, which is the amount of money you put into the annuity, and the returns that the underlying investments in your annuity earn on that capital over time. over time.

The most popular type of variable annuity is a deferred annuity. Often used for retirement planning purposes, it aims to provide a steady stream of income (monthly, quarterly, annually), beginning at some point in the future. There is also immediate annuitiesthat start paying income immediately.

You can purchase an annuity as a lump sum payment or as a series of payments, and the account value will increase accordingly. In the case of deferred annuities, we often speak of accumulation phase. The second phase is triggered when the annuitant asks the insurer to start the income stream, often called the payment phase. Most annuities will not allow you to withdraw additional funds from the account once the payout phase has begun.

Variable annuities should be considered long-term investments, due to limits on withdrawals. Typically, they allow one withdrawal per year during the accumulation phase. However, if you make a withdrawal during the term of the contract redemption periodwhich can last up to 15 years, you will usually have to pay a redemption fee.As with most retirement account options, withdrawals before age 59.5 will incur a 10% penalty tax.

Variable annuities vs fixed annuities

Variable annuities were introduced in the 1950s as an alternative to fixed annuities, which provide a guaranteed, but often small, payout during the annuity phase. (The exception is the fixed income annuity, which has a moderate to high payout that increases as the annuitant ages).

Variable annuities allowed buyers to take advantage of rising markets by investing in a menu of mutual funds offered by the insurer. The benefit was the possibility of higher returns during the accumulation phase and greater income during the payout phase. The downside was that the buyer was exposed to market risk, which could lead to losses. With a fixed annuity, on the other hand, the insurance company assumes the risk of delivering the return it has promised.

Advantages and disadvantages of the variable annuity

To decide whether to invest in a variable annuity rather than another type of investment, it is worth weighing the pros and cons.

Here are some details for each side.

Advantages

  1. Variable annuities grow tax-deferred, so you don’t have to pay tax on investment gains until you start receiving income or making a withdrawal.This also goes for retirement accounts, such as traditional IRAs and 401(k), of course.
  2. You can tailor the income stream to suit your needs.
  3. If you die before the payout phase, your beneficiaries may receive a guaranteed death benefit.
  4. Funds from an annuity are closed to creditors and other collectors. This is also generally the case for pension plans.

Disadvantages

  1. Variable annuities are riskier than fixed annuities because the underlying investments can lose value.
  2. If you need to withdraw money from the account due to a financial emergency, you may have to pay redemption fees. Any withdrawals made before age 59.5 may also be subject to a 10% penalty tax.
  3. The fees on variable annuities can be quite high.

The essential

Before purchasing a variable annuity, investors should read the prospectus carefully to try to understand the expenses, risks, and formulas for calculating investment gains or losses. Annuities are complicated productsso it might be easier said than done.

Keep in mind that among the many fees, such as investment management fees, mortality fees and administration fees, and fee for any additional passenger, the expenses of a variable annuity can add up quickly. This can hurt your long-term returns, compared to other types of investments.

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